New report debunks investment myths

Small-cap investors may be buying into the sector for the wrong reasons given the questionability of some conventional wisdoms that attract investors to smaller stocks.

One factor that has attracted investors to the junior end of the market is the “small-cap effect" – the perception that the minnows can deliver superior returns in exchange for higher risks that comes with their lack of scale. Another is the belief small caps outperform in a market upswing as they are seen to be more cyclically sensitive.

But there is little evidence to support either rationale, according to analysts at JPMorgan, and this will have a significant impact on investors as it has a direct bearing on the filters one should use in picking winners from the sea of junior names.

“Sitting in small caps as a group and hoping to get above market returns doesn’t seem to work," JPMorgan equities strategist Paul Brunker said. “It’s more the micro factors than macro ones [that would drive outperformance]."

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While there are times when small caps have run well ahead of their larger peers, there isn’t a lot of evidence to suggest that this is related to the small-cap effect.

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JPMorgan constructed a portfolio with the same sector weightings as the S&P/ASX Small Ordinaries but using large caps instead. It found the top 200 stocks at small-cap weights performed nearly as well as their junior counterparts over the past six years and with much lower volatility.

The idea that small companies generate higher beta – meaning they outrun a climbing market and fall harder during the down times – may also not hold water. The broker found that the Small Ordinaries underperformed for much of the 1994-2001 bull run and only managed to match big caps in the rising market of 2005-07.

However, this doesn’t mean investors should necessarily be underweight on emerging companies. In fact, Brunker believes that having a bias for small caps is justified but that has more to do with the challenges facing bigger companies.

“The large-cap universe is increasingly struggling for earnings growth," he says. “Bigger companies will always find it harder to generate growth and that is particularly true when you dominate your industry. So their margins are probably not going to go much higher and could probably come down."

Small caps aren’t as constrained. They tend to be niche players and operate in fragmented markets that provide better growth options and room for margins to improve. They also tend to attract less regulatory and political scrutiny.

Merger and acquisition activity is another supportive factor for the sector. Observers anticipate a pick-up in corporate activity over the next 12 months, and while this is likely to occur across the market, smaller companies stand to benefit more from this development given that they are usually the targets.

History has shown that the share prices of target firms almost always jump significantly on takeover news, while the bidder’s share price remains flat on average.

Thus, investors who can pick small-cap stocks with superior growth potential, fewer risks to earnings and corporate appeal are likely to do better, regardless of which part of the cycle we are in.

This means companies like frozen pie maker
Patties Foods
and vitamin company
Blackmores
are well positioned given their strong brands in their niche markets, and ability to continue to grow market share in Australia and, in particular, Asia.

While both companies can arguably be described as big fish in a small pond, the opposite is true for
Miclyn Express Offshore
. JP Morgan describes the marine services company to the oil and gas industry in Asia Pacific and the Middle East as a small fish in a growing global pond.

All brokers polled on Bloomberg have an equally bullish view of Miclyn given its earnings leverage to the rising utilisation rate for its vessels and increasing market penetration.

Despite the upbeat outlook, the stock trades at an attractive one-year forecast price-earnings of under eight times.

Miclyn shares eased 0.5¢ to $1.85 yesterday while the average broker price target is $2.09.

Another stock that might share many of the positive traits listed above is struggling toll-road operator
ConnectEast Group
.

The last few traffic updates have lifted confidence that it has turned around its fortunes after initial traffic flow failed to impress.

Management said that trips on the Victorian toll road continued to rise and hit a record 182,000 average daily trips in October – making it one of the state’s busiest roads.

Some observers are becoming confident about ConnectEast after it nearly collapsed during the financial crisis. Linwar Securities has given the stock an “outperform" recommendation and price target of 78¢ as it sees the group’s EastLink tollway as an undervalued quality asset. ConnectEast closed unchanged at 44¢.

A re-rating of the stock is likely to re-awaken takeover speculation in ConnectEast following the takeover bid for Intoll Group. Transurban is seen to be a natural acquirer as EastLink will complement its CityLink tollway in Melbourne.